As the world anticipates Bernanke's speech on Friday - which most do not expect to explicitly say "NEW-QE-is-on-bitches" - we started thinking just what it is that he can suggest that would provide more jawboning potential. His speech is likely to lay out 'lessons learned' and outline the various conventional, unconventional, and unconventional unconventional policy options available (as we noted here). While open-ended QE, cutting the IOER, and 'credit-easing' are often discussed, none would be a surprise; this reminded us of an article from Morgan Stanley two years ago - after QE2 - that raised the possibility of Price-Level Targeting (PT), which is quite different from Inflation-Targeting. While its cumulative effect could be anti-debtflationary, it is however tough to communicate, reduces the Fed's inflation-credibility, and could be seen as inconsistent with the Fed's dual mandate. Our hope is that by understanding this possibility, the mistaken shock-and-awe is dampened.
Via Morgan Stanley; October 2010 - From QE2 to PT1?
...with likely little bang for the additional QE buck at this stage, the Fed is looking for ways to complement asset purchases with an appropriate communications strategy. Price level targeting (PT) could be such a strategy. While certainly not our central case, we think that the adoption of PT would be a reasonable course of action for the Fed, especially if downside risks materialise: preventing deflation is preferable to having to fight it.
And some Fed officials’ recent statements [which fits with Rosengren's recent comments also], as well as the minutes of the September FOMC meeting, suggest that PT is being debated within the FOMC. Under PT, the central bank has to make up for past misses of the inflation target. The advantage of PT is the automatic stabilisation of inflation expectations when the central bank misses the target; and inflation expectations are crucial for the transmission of monetary policy when interest rates have hit zero.
The difference between PT and the more familiar inflation targeting (IT) is that under PT the central bank has to make up for past misses of the inflation target, while IT lets bygones be bygones. This becomes crucial in times of sustained misses of the target. At present, the Fed would have to engineer inflation that is higher than its (implicit) target for a while, to make up for downside misses. The advantage of PT is the automatic stabilisation of inflation expectations when the central bank misses the target; and inflation expectations are crucial for the transmission of monetary policy when interest rates have hit zero.
We think that there are two crucial advantages to PT at the current juncture:
- PT would help to stabilise inflation expectations: Perhaps the most important channel by which monetary policy affects demand in the economy is through its impact on real interest rates. In an environment where the main policy instrument, the short-term policy rate, is constrained by the ‘Zero Lower Bound’, a CB can affect the real interest rate only through inflation expectations. According to New York Fed President Dudley: “ … [T]he further the Fed fell behind its inflation objective in the near term, the more inflation would need to increase in order to push the actual path of prices up to the path consistent with price stability over the long run. To the extent this policy was more credible, it might do a better job keeping inflation expectations from falling. This might make monetary policy more stimulative …”
- Debtflation: Making up for past inflation undershoots through higher inflation helps highly leveraged public and private sectors with their debt burdens
However, there are a number of objections to PT:
- PT is difficult to communicate and hence not transparent: We disagree. The idea that past undershoots have to be compensated by overshoots such that inflation is on target ‘on average’ should not be difficult to communicate (‘average inflation targeting’). In fact, as the above example demonstrates, the Fed would only need to communicate four pieces of information: i) The price index to be targeted; ii) The average inflation target (say 2%) and hence the (slope of the) price path; iii) The starting point of the price path; and iv) The end point of the price path, at which the Fed exits PT and resumes normal service, i.e., reverts to IT. With this information, markets and the public could easily establish the implied average inflation rate. This could then be updated each month as new price index data comes in. Indeed, the Fed could itself publish the inflation rate it targets in regular intervals, e.g., as part of the statement following each FOMC meeting.
- The credibility of the Fed’s inflation target could be jeopardised: This is indeed a risk; if mismanaged, it could unhinge the very inflation expectations it is meant to stabilise. It would ultimately lead to higher, not lower, real interest rates as nominal yields would climb. Yet, we think it is possible for the CB to minimise such risks if it handles the communications aspect of PT appropriately, e.g., by announcing the four basic parameters sketched out above and by clarifying that it is a temporary policy. Fed Chairman Bernanke himself has in the past, in a piece of friendly advice dispensed to the BoJ, expressed confidence that this risk should be manageable: “publicly announced price-level targets would help…manage public expectations and…draw the distinction between a one-time price-level correction and the…longer-run inflation objective”.
- PT (and IT) is inconsistent with the Fed’s dual mandate: Not true, in our view. First off, the notion that PT/IT implies exclusive focus on inflation at the expense of the employment goal is a misunderstanding. In a world where monetary policy cannot permanently affect output and employment, all a CB can do is attempt to achieve the maximum sustainable level of employment that is consistent with price stability, exactly as the Fed’s dual mandate prescribes. But that is exactly what IT is about: under IT, a CB attempts to engineer a level of nominal spending (growth) that is consistent with stable inflation. Higher levels of spending would increase inflation; lower levels would decrease inflation. In short: stable inflation and sustainable employment are two sides of the same coin. Ben Bernanke again: “I subscribe unreservedly to the Humphrey-Hawkins dual mandate, and I would not be interested in the inflation-targeting approach if I didn’t think it was the best available technology for achieving both sets of policy objectives”.
Bottom line – it could be done: We think that the hurdles to PT are far from insurmountable in principle. At the current juncture – with a base case for inflation and real activity that FOMC members regard as “unacceptable” and plenty more potholes on the road to recovery – the bar is also lower than ever before. Throughout this crisis, CBs have shown that they are prepared to pull out all the stops to prevent the worst, and, most importantly, have understood that there are benefits to being proactive.
In the era of QE and CE (credit easing), moving from IT to PT is but a small step.
Yet, a small step for a central bank could be a giant leap for financial markets.
Full document below: